QE Forever and its implications for your portfolio

By Ankur Shah

Repeated monetary interventions by the world’s central bankers have forced investors into becoming speculators. Unfortunately, this conversion was not unintended as the Federal Reserve was quite clear in its intentions of forcing investors into riskier assets.

Maybe I’m “old school,” but investing once meant the judicious placement of capital over the long-term in companies with strong economic moats, excellent management teams and trading at reasonable valuation levels. The reality is that we’re now in a market environment where investors speculate on further central bank interventions as the basis for their investing decisions and not fundamentals.

On Thursday, Sept. 13 the Federal Reserve announced QE 3, a program to buy $40 billion worth of Mortgage Backed Securities (MBS) on an open ended basis. The $40 billion in purchases will be in addition to the $45 billion in longer term securities being purchased through Operation Twist. The Fed also announced an extension of its Fed funds target range of 0-0.25% through 2015.

Effectively the Fed is attempting to artificially stimulate the housing market by reducing mortgage rates and push investors into riskier assets such as stocks by keeping interest rates exceptionally low for an extended period of time. With 30-year mortgage rates already at historic lows it’s unlikely that the Fed’s policy will be enough to spark a recovery.

It’s clear that both QE 1 and QE 2 failed to spark a real recovery in either the economy or the real estate market. The only tangible impact from the prior rounds of quantitative easing was a spike in the stock market. QE 3 will not be an exception. With markets rallying globally, the Fed was successful in its efforts to boost share prices at least in the short-term.

The question remains why did the Fed decide to launch QE 3 with the U.S. stock market at a 4-year high, inflation at the high end of its targeted range and interest rates at historic lows? The only answer in my view is that they are in panic mode because the global economy is entering a new phase of the crisis that began in 2008. The only reason why inflation hasn’t exploded higher is that bankers are scared to lend.

When the Federal Reserve engages in quantitative easing it creates money “out of thin air” and purchases assets such as government bonds or mortgage backed securities from banks or other financial institutions. The funds received by the banks can then be lent out as loans to customers or retained as excess reserves with the central bank.

The recent increase in excess reserves is unprecedented from a historical perspective. Essentially, banks aren’t lending out their excess reserves because they are afraid of credit losses. Thus, M1 (money supply) fails to increase at a multiple of the adjusted monetary base because banks fail to expand credit through the fractional reserve banking process. The decline in the M1 multiplier to below 1 reflects this dynamic.

So, what does this all mean for investors? I think the most important question you need to ask yourself is whether we’re going to have inflation or deflation in the future. Despite the build-up of excess reserves, the Fed hasn’t pursued its “nuclear” options. The Fed could begin with cutting the interest it pays on excess reserves and theoretically there is no limit on the types of assets the Fed can purchase. With the Fed effectively going “all-in” with its unlimited large scale asset purchases (LSAP), the future is going to be inflationary.

In terms of the major asset classes, investors in fixed income will see the biggest losses in a highly inflationary environment. Even equities have a mixed record when it comes to hedging against the ravages of inflation.

Jeremy Siegel, the author of “Stocks for the Long Run,” has stated that at inflation rates above 5% stock performance begins to falter. Although equities as an asset class may not be attractive, I continue to believe that the route to outperformance is to identify individual stocks with strong economic moats, trading at reasonable valuations and priced with a margin of safety.

Finally, all investors will need a portion of their portfolios allocated to precious metals and commodities. Since the beginning of 2007, gold is up 181%. Over that same period the S&P 500 is up only 3%.

Gold continues to reflect the ongoing currency debasement being pursued by central bankers globally. With both the Federal Reserve and ECB committed to “unlimited” asset purchases, the fundamental outlook for gold remains positive.

Most investors will be losers in terms of their portfolios over the next few years. Those that make the right call in terms of inflation vs. deflation and position accordingly will walk away as winners.

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